ESKOM's announcement last week that it seeks a 45% annual increase in electricity prices over the next three years was bad enough. But the fact that the resulting rise in inflation will affect interest rates is enough to enrage the average consumer.

Past and future electricity price hikes were one of the reasons mentioned in the Reserve Bank's most recent monetary policy committee (MPC) statement for keeping interest rates unchanged.

The bank has cut interest rates by five percentage points since December 2008, bringing the prime overdraft rate to 10.5%, but disappointed consumers hoping for another last cut when it met in September. This week sees another MPC meeting - the last chaired by governor Tito Mboweni - but he has already indicated he's in no mood for further easing.

Interest rates are used as a tool to encourage or discourage demand in the economy. The question that immediately comes to mind is why should electricity prices, which have nothing to do with demand in the economy, have an effect on interest rates?

This is all the more pertinent because it's clear that demand has died a painful death in SA. Whatever inflation there is - 6.4% in August - isn't being caused by excessive consumer spending.

Still, despite the death of demand, inflation is still above the bank's 3% to 6% target range and inflation in 2009 won't fall within the target range on a sustainable basis.

Credit demand does a duck

The evidence that demand is dead was underlined by last week's retail sales figures for August. According to Statistics SA, real retail sales fell by a massive 7% year-on-year in August, compared with a 4.1% decline in July. The market was expecting a decrease of about 3.2% in August, which shows that consumer demand is much weaker than people had thought. It's significant that, despite swift and deep interest rate cuts, the consumer hasn't responded.

This weakness in demand is evident in the Reserve Bank's September Quarterly Bulletin, which shows household consumption expenditure (HCE) has been in recession for a year. HCE differs from retail sales in that it includes services as well. Tellingly, the pace of decline in HCE sped up in the second quarter, to 5.7% - laughing off the interest rate cuts that had taken place until that point.

As if further evidence is needed that credit spending isn't taking place, one needs only to look at the figures for private sector credit extension. This declined by 0.1% month-on-month in August, taking the annual rate of change to a minimal 2.9%. Credit demand has all but disappeared from the economy.

With all this evidence that consumers and companies are punch drunk, the fact that electricity price hikes will prevent a further fall in interest rates will stick in the craw for consumers. However, there's a good reason why the Reserve Bank shouldn't cut interest rates further now.

Tomorrow always comes

The fact is that interest rates work with a lag, and, in time, demand in the economy will pick up again. When that happens, it becomes much easier for retailers to pass on electricity increases to their customers. Passing on the power price hike will be plain sailing if demand is so strong that consumers are willing to pay the extra cost. If interest rates are cut further now, the Reserve Bank runs the risk of that happening in future.

Mboweni must be thinking back to 2004 and 2005, when the Reserve Bank cut interest rates by 0.5 percentage points in each year. These reductions, coming after aggressive cuts in 2003, created a culture of free and easy credit and helped consumers spend as if there were no tomorrow. But tomorrow did come for them, in a very painful way. Mboweni is trying to avoid a repeat of past mistakes.

And while it may seem as if the electricity tariff has nothing to do with consumer demand and should therefore not play a role in central bank decisions, this isn't the case. In an environment of roaring consumer demand, a power price escalation will be passed on easily, creating an inflationary spiral.

While economists generally don't expect interest rates to be cut again this week, their thoughts are already turning towards 2010, when rates may begin rising from the third quarter.

The electricity price shock will play a role in the timing. The power tariff increase means that SA can afford less consumer demand than would otherwise be the case. Unfortunately, we have to cut our coat according to our cloth.

- Fin24.com